But the composition of the report revealed considerable weakness in key sectors of the economy and has negative implications for the final quarter of the year.

Consumer spending, accounting for about 70% of GDP, contracted at a 3.1% pace in the third quarter and subtracted 2.25 percentage points from the overall GDP growth rate.

This was the first quarterly decline in consumer spending since 1991 and the largest decline since 1980 ― both were recessionary periods.

In view of the heightened financial market turmoil in October and plummeting consumer confidence during that month, consumer spending definitely is heading for another sizable contraction in the fourth quarter of this year.

The housing production component of GDP, residential fixed investment, contracted at a 19.1% pace in the third quarter and subtracted 0.72 percentage point from the GDP growth rate — a performance that’s in the range of experience for the past two-and-one-half years. The downward momentum in housing starts through September points toward a similarly weak performance in the fourth quarter as housing continues to weigh on the economy.

Everything considered, it’s inevitable that the decline in GDP will accelerate in the fourth quarter and some shrinkage early next year also is in the cards.

This all spells a recession “call” by the Business Cycle Dating Committee at the National Bureau of Economic Research, although it’s difficult to predict when the call will be made.
 

The Libor market has been the most glaring example of tremendous stress in short-term credit markets. The spreads between Libor rates and comparable-maturity Treasury rates (so-called TED spreads), as well as spreads of Libor over expected federal funds rates (OIS spreads), exploded to record highs in September and early October.

These spreads have come down considerably from those peaks, although they still are quite large on a historical basis.

The Fed launched its new commercial paper facility on Oct. 27, targeting three-month paper, and the market response has been encouraging.

Although we do not know exactly how much the Fed bought, sales of commercial paper due in more than 80 days surged to a record $67 billion on Oct. 27 on 1,500 issues, compared with average daily issuance of less than $7 billion during the previous week.

It’s clear than the Fed’s new commercial paper facility has already provided desperately needed access to credit markets for a fair number of sizable American businesses. [return to top]
 

Prices of precious and industrial metals also were at or near their respective highs around mid-2008.

Accumulating evidence of weakening conditions in U.S. and global economies has helped shepherd commodity prices downward in recent months, providing badly needed benefits to consumers as well as to most business firms, other than those producing the commodities. Falling commodity prices have also put downward pressures on key measures of overall and core inflation, allowing the Fed and foreign central banks to move inflation concerns to the back burner.

The most stunning price declines in commodity markets have been recorded in the global oil market.

The key WTI (West Texas Intermediate) price approached $150 per barrel in early July, easily an all-time high in both nominal and real (inflation-adjusted) terms. In the closing days of October, this price was approaching $60 per barrel despite a temporary decline in the dollar, and further declines are likely as the global recession deepens.

Gasoline prices have been following oil downward, providing some relief for consumers and businesses at the pump. [return to top]
 

The funds rate now is down by 4.25 percentage points from the recent high in September 2007 and is equal to the rate that prevailed from mid-2003 to mid-2004 when the Fed was fighting a perceived deflation threat.

The Oct. 29 FOMC statement emphasized the weakening economy, highlighting weak consumer and business spending and raising the prospect of a slowdown in growth of exports. Ironically, housing was not discussed.

These weakening patterns were evident in the third-quarter GDP report that was released the following day.

The FOMC statement also noted that “the intensification of financial market turmoil” is likely to put further downward pressure on spending by households and businesses as it becomes more difficult for them to obtain credit.

Although there has been some recent evidence of improvement in credit markets, stress certainly remains high and the FOMC’s judgment undoubtedly is on target.

On the inflation front, the FOMC statement stressed recent declines in the prices of energy and other commodities and noted that the weaker prospect for economic activity will help to reduce inflation in coming quarters “to levels consistent with price stability” — presumably meaning around 1% for core consumer price inflation.

With respect to the balance of risks going forward, the statement stressed downside risks to growth and didn’t even raise upside risks to inflation — a rare position for the inflation-wary Fed.

It’s highly likely that the Fed will enact further declines in the federal funds and discount rates in the near future, moves that will contribute to the steep upward slope in the Treasury yield curve. That’s a good thing for the economy.

We expect quarter-point cuts at both the Dec. 16 and Jan. 29 FOMC meetings, taking these rates to historic lows that should be maintained for most of next year. [return to top]
 

As a result, the Homeowner Vacancy Rate remained at 2.8%, down only slightly from the record high posted in the first quarter of the year.

The rental market also shows serious signs of oversupply. The overall rental vacancy rate was 9.9% in the third quarter, down a bit from the first half of the year but still quite high by historical standards. Rental vacancy rates remain historically high in both the single-family and multifamily components of the housing market.

For the overall housing market ― single-family, multifamily and manufactured homes — vacant year-round housing units on the market (for-sale or for-rent) came to 4.8% of the total stock in the third quarter, down only slightly from the record high posted earlier this year.

We estimate that this translates into nearly 1.6 million “excess” units on the market, and there’s also a sizable supply of vacant units currently held off the market. [return to top]
 

The “good” news is that the month-to-month declines have been slowing down on a seasonally adjusted basis, and that’s a good way to assess the momentum in house prices.

On this basis, the 20-City Composite fell at an annualized rate of 12% in both July and August, compared with 23% in the first quarter of the year.

We expect the rate of house price decline to subside further as time passes, with price levels stabilizing by late next year. Of course, historical experience with declining house prices is very rare and it’s difficult to make house-price forecasts with a high degree of confidence. [return to top]
 

It’s true that sales of both new and existing single-family homes perked up in September, but it’s unlikely that those moves reflected fundamental stabilization of housing demand.

Existing-home sales are being buoyed by sales of foreclosed homes, at fire sale prices, through multiple-listing services — hardly a sign of market vitality. And the small September bounce in new-home sales followed a sizable downward revision in August, leaving the downward trend intact.

We now expect a bottom for new-home sales in the first quarter of 2009, followed by a tepid recovery process over the balance of the year.

Housing starts probably won’t hit bottom until mid-2009, and tightness in markets for land development and construction loans certainly will limit the vigor of the subsequent recovery. [return to top]
 

Another economic stimulus plan, designed to reduce the imbalance between housing demand and housing supply, is urgently needed to break the downward spiral in house prices and to stabilize economic and financial market conditions.

A strong tax incentive for home buying should be at the top of the list of options considered by the Congress immediately after the elections. [return to top]
 

Get the metro forecast with in-depth analysis, overviews and downloadable Excel tables.

To learn more, visit www.HousingEconomics.com. [return to top]